Are We There Yet?

February 8, 2016
DoubleLine Macro-Asset Allocation Team
Sam Garza, Portfolio Manager
Fei He, Quantitative Analyst
Ryan Kimmel, Analyst

333 S. Grand Ave., 18th Floor || Los Angeles, CA 90071 || (213) 633-8200

Are We There Yet?

The Fed has got to dial this rhetoric
back or the markets are going to
humiliate them with further declines.1
--Jeffrey Gundlach

Figure 1: Universe of Developed Market Government

Bonds with Negative Yields
As of January 29, 2015
$6,000

$5,000

Highlights

The Federal Reserve (Fed) is currently the only

developed country central bank tightening
monetary policy. According to the Wu-Xia Shadow
Federal Funds Rate, the Fed actually started
tightening interest rates as early as June 2014,
equivalent to 300 basis points (bps), plus the 25
bps added in December.
We find that rising Wu-Xia Shadow Federal Funds
Rates over the past one and a half years coincide
with a rising U.S. Dollar (USD), tightening financial
conditions, plunging commodity prices and
widening credit spreads.

We also find the pace of the rise in Wu-Xia Shadow

Federal Funds Rates is comparable to the previous
rate hiking cycles. In fact, we might be in the late
innings of this rate hiking cycle already.

We believe the pace of Fed rate hikes will be much

more gradual than their projections released in
December 2015. If the global economy slows down
further, we could see the Fed capitulate and be
forced to move back to the easing policy again.

The Bank of Japan (BoJ) shocked the global financial

world by moving towards negative rates at the end of
January while keeping the door open for further cuts.
While Japan is not the first country to deploy negative
interest rates its impact to the global financial markets
should not be underestimated. Currently, 25% of the
global economy is experimenting with negative policy
rates. Over $5 trillion of government debt is trading
with negative yields (Figure 1).
In the meantime, the European Central Bank (ECB)
may take their interest rates even more negative and
Super MarioMario Draghi, President of the ECB

USD Billion

$4,000

$3,000

$2,000

$1,000

$0

Source: JP Morgan, DoubleLine

may announce a plan to buy even more bonds in

March. Furthermore, the Bank of England (BoE) may
not hike until mid-2017 well after the country decides
whether or not to remain in the European Union.
Meanwhile, the Fed is currently the only developed
country central bank tightening monetary policy. In
December, the Fed increased the federal funds rate
by 25 bps, the first move in seven years.
Historically, the Fed has used its funds rate as the
primary instrument of monetary policy. Lowering the
federal funds rate intends to provide economic
stimulus and promote employment while raising it
prevents the economy from overheating and thus
tempers inflation. In response to the global financial
crisis in 2008 the Fed reduced the Federal Funds Rate
to near zero. In tandem, the Fed employed
unconventional policy tools such as large-scale asset
purchases (commonly known as QE, or quantitative
easing) and forward guidance as its primary policy
tools. With the key policy rate floored at zero
measuring the extent of Fed monetary policy
becomes a real challenge.
Recently, University of Chicago Professor Cynthia Wu
and Merrill Lynch researcher Dora Xia developed a
statistical Shadow Fed Funds Rate model as a

1. Tick, tick, tick Inside ETF Conference, Florida, January 25, 2016.

Are We There Yet? February 8, 2016

Are We There Yet?

substitute, or proxy, for the Federal Funds Rate. As
shown in Figure 2, the Wu-Xia Shadow Fed Funds Rate
can go negative.
Figure 2: Wu-Xia Federal Funds Rate
As of January 31, 2016
6

Effective Fed Funds Rate, end of month

Wu-Xia Shadow Fed Funds Rate

3
2
1

0
-1
-2

-3
-4

Source: Bloomberg, DoubleLine

Figure 3 shows the Fed has used unconventional policy

measures to successfully lower the shadow rate. It is
worth pointing out that the Wu-Xia Shadow Federal
Funds Rate is not the only shadow rate model. But the
common dynamics among different shadow rates
point to the same economic impacts.
Figure 3: Wu-Xia Shadow Fed Funds
As of January 31, 2016
5
4

QE 1

3
2
1

Bernanke
Jackson Hole
speech hints at
QE 2

QE 2

Operation
Twist
Extension of
Operation
Twist

QE 3

QE Taper and
Implicit Tightening
Fed Hikes
12/17/15

0
-1
-2
-3
-4

Source: Bloomberg, DoubleLine

At DoubleLine, we find the Fed started explicitly

tightening the shadow rate or the effective interest
rate as early as June 2014. The Wu-Xia Shadow Rate
reached its lowest level of -3.0% in May 2014 during
the Feds taper, just a few months before the Fed

completed their bond buying program. Since then the

shadow rate rose steadily back to zero in November
last year, just before the Fed made its first interest rate
hike. That is a 3% interest rate hike in an 18 month
period.
Interestingly, the USD started strengthening, financial
conditions started tightening, oil prices started
plunging, high yield spreads started widening all
around mid-2014 (see Figures 4a to 4d on the following
page). We do not think this is a coincidence. A higher
effective interest rate in the U.S. was the likely
culprit. In fact, we believe the Fed effectively started
tightening its monetary policy in the summer of 2014.
Figure 5 compares the rise in the Shadow Federal
Funds Rate since May 2014 versus the previous four
rate hiking cycles. Based on historical tightening cycles,
we should be getting close to the end of this hiking
cycle.
What will the Fed do in the coming months? In line
with market expectations, we believe the Fed will likely
adjust its policy rate projections lower from the current
four hikes forecasted for 2016. While the market is
currently pricing in less than one rate hike by the end
of the year the Feds projections will be highly
dependent on the incoming economic data between
now and the next Fed meeting on March 16th. If the
economic data deteriorates further the Fed will likely
capitulate to the markets expectations. However, if
the data improves over the next few months the
market may have to reprice. Needless to say, we will be
watching the economic data closely.
Under the scenario where the U.S. enters a recession
this year the Fed may do more than halt its hiking
cycle. Potential spillover effects from a weaker global
economy could incite the Fed to reverse course and
move back to easing monetary policy again. As
indicated in Figure 6, thats exactly what happened to
other central banks (just name a fewECB, Peoples
Bank of China, Bank of Canada and Reserve Bank of
Australia) that hiked post-global financial crisis but had
to reverse those moves as their economies slowed. 3
Are We There Yet? February 8, 2016

Are We There Yet?

Figure 4a: Shadow Rate and Financial Conditions

Figure 4b: Shadow Rate and U.S. Corporate High Yield Spread
As of January 31, 2016

As of January 31, 2016

0.5

Goldman Sachs Financial Conditions (RHS)*

101.0

Barclays U.S. Corporate High Yield Spread (RHS)*

7.5
7.0

Tighter Conditions
100.0

-2

99.5

-2.5

6.5
-1

6.0

-1.5

5.5
5.0

-2

4.5

US Corp HY OAS (%)

100.5

-1

-1.5

-2.5

99.0

-3
-3.5

4.0

-3

98.5

As of January 31, 2016

125

0.5

120

115

-1

-1.5

110

-2

105

Trade Weighted USD

-0.5

-2.5

25

Wu-Xia Shadow Fed Funds Rate (LHS)*

WTI (RHS)*

35

-0.5

45

-1

55

Shadow Effective Fed Funds Rate (%)

Wu-Xia Shadow Fed Funds Rate (LHS)*

USD Trade Weighted (RHS)*

3.0

Figure 4d: Shadow Rate and West Texas Intermediate (WTI)

As of January 31, 2016

0.5

3.5

-3.5

Figure 4c: Shadow Rate and U.S. Dollar (USD)

Shadow Effective Fed Funds Rate (%)

8.0

-0.5

Financial Conditions

-0.5

Wu-Xia Shadow Fed Funds Rate (LHS)*

65

-1.5

75

-2

85

-2.5

100

-3

WTI (Inverted)

Shadow Effective Fed Funds Rate (%)

101.5

Wu-Xia Shadow Fed Funds Rate (LHS)*

Shadow Effective Fed Funds Rate (%)

0.5

95

-3
105

-3.5

95

-3.5

Figure 5: Effective Fed Funds During Previous Hiking Cycles**

Figure 6: Central Bank Policy Rates (%)

As of January 29, 2016

1994-1995
4

1999-2000
2004-2006

New Zealand
South Korea

2014-2016
6

PCT Change

Australia

Norway
Sweden
Denmark

0
3

-1
2

-2

-3

-4
-40

-35

-30

-25

-20

-15

-10 -5
0
5
10 15
Months Around Fed Tightening

20

25

30

35

40

-1

Charts Source: Bloomberg, DoubleLine

*LHS= Left Hand Side; RHS = Right Hand Side
**2014-2016 Hiking Cycle proxied from Wu-Xia Shadow Fed Funds Rate

4
Are We There Yet? February 8, 2016

Are We There Yet?

Bibliography
Wu, Jing Cynthia & Xia, Fan Dora. Measuring the Macroeconomic Impact of Monetary Policy at the Zero Low Bound forthcoming in
Journal of Money, Credit, and Banking.
Definitions
Wu-Xia Shadow Federal Funds Rate - The shadow rate model is not bounded by the zero lower bound and can be used as a proxy to
measure the extent of monetary policy when the zero lower bound has been reached and unconventional monetary policies have been
deployed, examples include the Federal Reserves large-scale asset purchase program and forward guidance.
Barclays U.S. Corporate High Yield Index - A market value-weighted index which covers the U.S. non-investment grade fixed-rate debt
market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum
$150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.
Goldman Sachs Financial Conditions Index - A weighted index that tracks changes in interest rates, credit spreads, equity prices and
the value of the greenback.
Author Biographies

Samuel M. Garza
Portfolio Manager, Macro-Asset Allocation
Mr. Garza joined DoubleLine in 2009. Prior to DoubleLine, Mr. Garza was a Senior Vice President at TCW
since 2000 where he held several positions over the years ending with his last promotion to Senior Vice
President in 2005. Prior to TCW, Mr. Garza worked at Union Bank of California in the Commercial
Banking Group where he was involved with corporate loan underwriting. Mr. Garza holds a BA in
Business Economics from the University of California, Santa Barbara and an MBA from the Anderson
School of Management at the University of California, Los Angeles.
Fei He, CFA
Quantitative Analyst, Macro-Asset Allocation
Mr. He joined DoubleLines Macro-Asset Allocation team in 2014 as a quantitative analyst. Prior to joining the firm, he worked at PIMCO for three and half years as a quantitative research analyst where he
began in client analytics, advising clients on strategic asset allocation and later moved to emerging markets and commodities. Mr. He began his career at Absolute Return Capital Advisors as a portfolio/
research associate. He has published papers, including the Financial Analysts Journal. Mr. He holds an
MS in Financial Engineering from UCLA Anderson School of Management and a PhD in Molecular &
Medical Pharmacology from UCLA David Geffen School of Medicine. He graduated from Tsinghua University in Beijing with a BS in Biological Sciences & Biotechnology and is a CFA charterholder.
Ryan Kimmel
Analyst, Macro-Asset Allocation
Ryan Kimmel is an Analyst for DoubleLine Capitals Multi-Asset Growth Strategy. Mr. Kimmel joined
DoubleLine in 2012. Prior to DoubleLine, Mr. Kimmel was a Proprietary Trader at The Gelber Group,
trading currencies for the Foreign Currency Group. Before Gelber, Mr. Kimmel was an Investment
Banking Analyst in Morgan Stanleys Mergers and Acquisitions Group. Mr. Kimmel holds a BA in Business
Economics from the University of California, Los Angeles and holds an MBA from the Anderson School of
5
Management at the University of California, Los Angeles.
Are We There Yet? February 8, 2016

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Are We There Yet? February 8, 2016